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Keynesian vs Classical Economics

Essay By: WolfOfWhittier
Editorial and opinion


My take on Economics.


Submitted:Jan 30, 2014    Reads: 77    Comments: 0    Likes: 0   


Philosophers, economists, and politicians have been in dissension for the past 80 years, a disunity lead by opposing convictions concerning the principles of how to run an economy. In one corner, who have Adam Smith, touted as the world's first free-market capitalist; known as the father of modern economics and a major proponent of laissez-faire economic policies-(Smith, Lisa). Smith's magnum opus, The Wealth of Nations, expounds how rational self-interest , free competition, and minimal government intervention can lead to economic prosperity-("Adam Smith"). These popularized ideas became the foundation of classical economics. In the other corner stands John Maynard Keynes, a British economist whose philosophies have altered the theory and practice of modern macroeconomics at a fundamental level. His book, The General Theory of Employment, Interest and Money- published in 1936- formed the basis of Keynesian economics, contrasting the classical view that "supply creates its own demand" (Say's Law), and contending that aggregate demand determined the overall level of economic activity-("John Maynard Keynes"). In his attempt to solve the Great Depression, Keynes advocated for increased government expenditures and lowering taxes to stimulate demand; by influencing aggregate demand (equal, in a closed economy, to consumption plus investment plus government expenditure) through economic intervention policies by the government, economic growth can be jumpstarted during sluggish economic downturns-("Keynesian economics." Wikipedia.) . Classical economists claimed that free markets regulate themselves, when free of any intervention-("Classical economics." Wikipedia.). Identifying the most viable economic theory is merely circumstantial, meaning that that the theory in practice should be relative to a nation's economic situation.

When should the Keynesian model be put into effect? Well Keynesian's school of thought is a focus on short-run economic fluctuations in which the government plays an important role in mitigating economic recessions by influencing aggregate demand through activist stabilization; however, in the long-run, Keynes agreed with the classical model only for when the economy is at potential output-("Macroeconomics" ). But in the case of a recession, when the economy is not producing at full potential output, laissez-faire approach will dampen the economy. Classical economists maintained that cyclic swings in employment and economic output would be at a modest level and self-adjusting; this classical theory indicates that if aggregate demand in the economy fell, the resulting deficiencies in productivity and jobs would initiate a decline in wages and prices, and would induce employers to make capital investment and hire more workers, thus stimulating employment and economic growth. Keynes, though, held that structural rigidities and certain characteristics of market economies would cause aggregate demand to descend further by exacerbating economic weakness. He refutes the notion that lower wages can restore full employment by arguing that private businesses will not employ more people to produce goods or services that are not in demand. These ill business conditions will cause firms to reduce their investment plans and in turn reduce aggregate expenditures(Keynesian Economics. Ivestopedia). The decrease in wages will actually lead to a decrease in income, which will lead to decreased aggregate demand, as well as production, and with less output employment will rise, furthering the economy into a recession-("Macroeconomics" ). Since the market is imperfect and not self-sustaining during a recession, the government ought to apply certain aspects of Keynesian economics to fiscal and monetary policies: lower taxes, lower interest rates, and increase government expenditures. The decrease in taxes will lead to an increased aggregate income and allow for an increase aggregate consumption and saving (MPC & MPS) -("Fundamental psychological law") . Although, with these elements in place the government will fall into debt because it will be constantly barrowing money- rather than financing the government budget deficit through the printing of money, which leads to hyperinflation. But Keynes argued that the primary focus during a recession is to prime the pump through profuse spending to raise the GDP, and then during the good times should the debt be dealt with. This expansionary approach will shift the aggregate demand curve to the right, and in the short-run increase aggregate supply. But Keynesians believe that, because prices are somewhat sticky, fluctuations in any component of spending-consumption, investment, or government expenditures-cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase. A major component of the Keynesian model of economic activity is the "multiplier effect": "output increases by a multiple of the original change in spending that caused it"-(Alan S. Blinder). Therefore, a ten-billion-dollar increase in government spending could cause total output to rise by fifteen billion dollars (a multiplier of 1.5) or by five billion (a multiplier of 0.5) -(Alan S. Blinder). Once the economy is operating at potential output, the government, in an ideal state, should begin to abate its intervention, as to prevent overheating and pushing aggregate demand too far to the right-(Khan, Sal). If the government fails to recognize its potential output, and continues with incessant stimuli, inflationary gaps will occur, signaling that the economy is in the boom part of the trade cycle, overutilization of resources passed their capacity, factories operating with increasing average costs, and wage rates increasing because labor is used beyond normal hours at overtime pay rates.

(Macroeconomics)

When the gap is finally eliminated, equilibrium is achieved, with actual GDP equal to potential GDP but at a higher price level-("Inflationary Gap").

(Macroeconomics)

Mass deficit spending in government sponsored programs and work projects will not work in the long-run; once the economy reaches equilibrium during the short-run, certain aspects of classical economics should be applied in order to preserve the economic balance in the long-run.

What classical views should be applied? Well Say's Law, for it contradicts my dissertation, has been ruled out. Say's Law has been summarized by Keynes as aggregate supply creating its own aggregate demand; it essentially means that the aggregate production of goods and services in the economy generates enough income to exactly purchase all output-(Classical Economics). But what if an individual, as most of us do, decides to store his/her wealth as money? Will it not result in insufficient aggregate demand to purchase what has been supplied? Of course it will. To return to the summarization of supply creating its own demand, Steven Horwitz, professor of economics at St. Lawrence University, justifies this conjecture by stating that, "demanding products requires the possession of money, which in turn requires a previous act of supply". So if the previous act of supply was an individual selling his/her labor services for money, I would assume that whatever he/she is producing is in demand, and if it was not, then initially there would have no production of any goods or services being supplied. The only classical principle that holds some validity, in the context of economical equilibrium, is the Laissez-faire philosophy. Now that the government has restored balance, it should pull out and not interfere with the flow of the economy, unless a recession ensues again. It is the idea that an "invisible hand", originally proposed by Adam Smith, guides free markets and capitalism through competition for scarce resources-(Smith, Lisa). Smith assumed that individuals are self-interested, so they try to maximize their own good (implying wealth), and by doing so, through trade and entrepreneurship, society as a whole is better off - ("Invisible Hand"). People are naturally self-interested , that is true, but assuming that their actions to benefit themselves will always also benefit society is dependent on the condition of the society; if an individual is present in an unhealthy and unstable economy then he/she will be reluctant to invest into said economy, hence only benefiting themselves. But if placed in a healthy and stable economy (restored by the government), he/she will be less afraid to invest and try to maximize his/her profits, which is an action benefiting both parties. With the removal of the fear factor- by the government- Laissez-faire philosophy and the "invisible hand" theory should be held to truth- under circumstance of a prospering economy.





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